INTM552170 - Hybrids: hybrid transfers (Chapter 4): the financial trader exclusion - overview

The financial trader exclusion (FTE), in s259DE, relates solely to hybrid transfer deduction/non-inclusion mismatches arising from a payment or quasi-payment that is a substitute payment.

Substitute payments are very commonly made in commercial financial transactions. It is common for there to be chains of substitute payments, some between related parties, and if a transaction under which a substitute payment is made is looked at narrowly, a deduction non-inclusion mismatch arises. However, if the entirety of the chain of transactions giving rise to the payment is considered, there is usually no mismatch.

At the beginning of the chain of transactions there is a real non-deductible dividend and at the end a substitute payment treated as a tax-exempt dividend. Providing the financial trader brings all expenses and receipts into account in trading taxable profits, for example by being subject to tax on a dividend or substitute payment received, the financial trader gains no tax benefit. Consequently, there is a special rule (the financial trader exclusion) in Chapter 4, which applies to deduction/non-inclusion mismatches that arise because a financial trader can deduct the cost of the substitute payment in computing profits. This means that a related-party transaction in the chain of transactions does not of itself lead to counteraction; counteraction will only occur where the related party transaction is itself a ‘structured arrangement’, see INTM552150.

The purpose of the financial trader inclusion is two-fold

  • to prevent inappropriate counteraction of mismatches, and
  • to ease the compliance burden imposed on financial traders

As a result of this exclusion, excesses of deductions over inclusions, or under-taxed amounts, which fall within the terms of this exclusion are not taken into account in computing the extent of a hybrid transfer deduction/non-inclusion mismatch under s259DC, see INTM552100.

The financial trader exclusion does not apply to the class of transactions where the dual treatment condition is satisfied (that is, in-substance lending mismatches, see INTM552060.

For instance, there might be there is a repo or repo-like related party transaction in which a financial trader is the in-substance borrower and a related party is the in-substance lender. The financial trader has a tax-deductible financing expense, a quasi-payment. If the related party’s tax jurisdiction does not regard the transaction as an, in substance, lending and does not tax an amount corresponding to the quasi-payment as ordinary income, the dual treatment condition is satisfied. Whether the financing expense deduction is generally available or arises from the financial trader status of the in-substance borrower, the mismatch in respect of the quasi-payment is an arrangement that is capable of counteraction. There is no special feature which justifies application of an exclusion for financial traders.

It is also conceivable, albeit unlikely, that a dual treatment mismatch might arise where a substitute payment is a part of the mechanism for delivering a dual treatment mismatch. One jurisdiction may allow a tax deduction for accruing interest-like finance expense (a quasi-payment) but the other jurisdiction does not tax the return as an interest like financing return. In such a transaction a mismatch does not directly relate to the substitute payment itself. The financial trader exclusion does not apply in such circumstances. Note, however, it would be more likely that a real dividend, as against a substitute payment, would be incorporated in the mechanics of such a repo-like transaction as in the example at INTM552510.

The example below shows that in circumstances where the deduction is claimed by a financial trader, there is no actual deduction/non-inclusion mismatch when the relevant transactions are seen together.

Example – bank acts as stock lending intermediary

  • An investment entity (not a financial trader) which is a member of a group wishes to earn a stock lending fee by lending shares in the market. Its sister company, a UK bank, has many clients that may wish to borrow the shares and acts as an intermediary - on-lending the shares to its client.
  • The stock loan extends over the record date for payment of a dividend. Accordingly the client makes a substitute payment to the bank which in turn makes a substitute payment to its sister investment company.

Looking at the overall transaction, the issuer of the underlying instrument (the shares) makes a dividend payment which is not tax-deductible.

The third-party client receives a dividend which is not taxable (for example because of participation exemption) and makes a non-deductible substitute payment to the UK bank which is tax neutral for the client.

The UK bank receives a substitute payment, which is taken into account in computing its tax liability.

The UK bank makes a deductible substitute payment to its sister investment company, which is not taxed on it as the payment is treated as a real tax-exempt dividend.

Overall there are

  • two non-deductible payments, by the issuer and the client
  • two non-taxable receipts, to the client and the investment company
  • and additionally, one taxable receipt and one tax deductible payment to the UK bank

Therefore, it is tax neutral. It would not be appropriate for a mismatch to be countered in such circumstances and the effect of the financial trader should be to prevent this happening.

Two entities may benefit from a participation exemption relating to the same dividend but providing the client does not get a tax deduction for its substitute payment the position is neutral. Counteraction would apply to that transaction, which is not between related parties, only if it were a structured arrangement.